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Paid Off Mortgage and the Smith Manoeuvre

paid off mortgage and smith manoeuvre

This post was originally posted in 2009, but brought back to the foreground after some readers emailed me about the same topic.  I added a couple of comments below on how my philisophy on this matter has changed over the years.

A reader question that I’ve been getting quite a bit lately is, what if you’ve paid off your non-deductible mortgage while implementing the Smith Manoeuvre?  What do you do with the large remaining investment loan?

For new readers out there, let’s get into a little background information. The Smith Manoeuvre is a leveraged investment strategy where you borrow from your home equity to invest in income (or potential for income) producing assets.  Basically, you obtain a special kind of mortgage, called a re-advanceable mortgage, which increases the credit line limit as the mortgage is paid down.  The credit line is then invested.  There will come a point where the non-deductible mortgage gets paid off completely and the investor is left with a large line of credit that’s invested in the market.  If you are interested in this topic, you can find more detailed information about the Smith Manoeuvre here.

Besides jumping up and down in celebration, there a few options once the non-deductible mortgage is paid off.

  1. Keep the investment loan forever.  This is the main strategy if you follow the Smith Manoeuvre to a tee.  The rationale is to keep collecting the tax deductions for the remainder of your life.  I’m personally not too comfortable with that option.  More on this below.
  2. Pay off the investment loan completely over time.  The opposite of the above is to start paying off the investment loan once the non-deductible mortgage is wiped out.  Basically, the investor here would apply the old mortgage payments towards the HELOC.  The tax deduction would still apply, however at a reduced amount every year as the HELOC balance reduces.  I’m more in favour of this option, or the one below, as I’m not sure I would be comfortable having a large looming debt during retirement.  Even if it’s good debt.
  3. Pay off a portion of the investment loan.  This is a hybrid of the above strategy where the investor would pay down the investment loan down to a point where they are comfortable with the monthly payments.  The investor can decide how much per month they can afford to pay indefinitely and pay down the balance accordingly.  Of course, the investor would have to account for higher inflation years as it would affect his monthly line of credit servicing costs.

To answer the reader email, the three answers above are all correct, it’s up to the investor to decide how much risk they can swallow.  As I mentioned above, I will most likely be paying down my investment loan prior to retirement to ensure that the monthly payments are manageable even in times of high inflation.  Hopefully, at that point, the dividends from the investments will be head and shoulders above the required investment loan servicing costs.

For those of you with a leveraged portfolio, what is your long term plan?

Update 2017: Since starting the SM in 2008 and paying off our regular mortgage in 2010, we have not paid down our HELOC – not one dollar.  In fact, we continue to borrow from the HELOC as opportunities arise in the stock market.  If we ever get to the point of maxing out our credit limit (or if interest rates get out of control), we will likely start paying down the investment loan.  In the meantime however, we will continue to maintain the HELOC balance for the foreseeable future.  Here is the latest update on my SM investment account which falls within my financial freedom journey.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 39 comments… add one }
  • Kyle March 3, 2009, 8:35 am

    I live at home but have an income property so it is currently a writeoff. I have to have a majority of my mortgage paid off before I am allowed any readvancement. I currently hope to be open to readvances in the next year and a half. Would I be able to re-advance that mortgage, even though its already an income property, and invest the re-advancement implimenting the SM. And with using that re-advancement, am I able to put the first 5000$ into a TFSA and possibly a spousal account before having to invest in a taxable account thus having 10 000$ invested tax free and also having the interest from the re-advancement written-off? Thanks for all the great posts elsewhere everyone!!!!
    Kyle

  • Leveraged investor March 3, 2009, 8:41 am

    MDJ – Good post, but I think there’s a point that needs to be more explicit. In an “advanced” (advanced in time, so the bulk of the original mortgage or more is paid down) you are a significantly leveraged investor. So you need to be comfortable with two things

    – The continuing cash payment requirement
    – The level of asset leverage you have

    If either of these factors make you favour your third option, you should already stop readvancing your mortgage once the HELOC portion exceeds the level of investment leverage you want to tolerate, even if your non tax deductible mortgage is still not down to a balance of zero. You can then accelerate paydown of the mortgage and just stop readvancing.

    I did this thanks to a very cash-generous job for the past few years. Started 3 years ago with enough investments/savings to make a roughly 75% downpayment on my first house. But turned around and took out not only 25% as a mortgage (the part I could not afford in cash) but also 40% extra as an investment loan. I decided I felt comfortable with investment leverage equivalent to 50% of the house value maximum. So over the next 2 years I paid down the 25% and increased the investment loan from 40% to 50% but stayed there.

    I’m now down on my investment due to market conditions, unfortunately, but I followed my own asset allocation and can sleep well at night. I’m about to invest extra cash generated since then to increase my exposure to the market, but will keep the investment loan at the leverage level I decided I wanted to have.

  • FT FrugalTrader March 3, 2009, 8:55 am

    Kyle, any borrowed money put into a TFSA or RRSP is non deductible.

    Leveraged investor, you have some great points there. It is one idea to stop borrowing from the HELOC, but wouldn’t you be cutting your portfolio short if you are invested for the long term?

  • Four Pillars March 3, 2009, 9:09 am

    Definitely pay it down – I don’t want the extra risk (from variable interest rates) while in retirement.

    I also plan to be a lower tax bracket in retirement so the tax benefits will be less anyway.

  • Kyle March 3, 2009, 9:18 am

    Thanks FT!!!!
    Would I still be able to borrow against an already income producing investment property (with a HELOC mortgage) and invest in stocks/etf’s/etc from the re-advancement and still have that deductible?

  • Kyle March 3, 2009, 9:46 am

    And yet another question to go a step further. I’ve been going through books, blogs (here and redflagdeals.com) and what have you, How do you purchase your individual stock picks and avoid high costs of fee’s from institutions? If I am only paying off a principle of say 200-300$ every 2 weeks or once a month and am re-investing that how does the SM even make sense if I have all these fee’s? Is it better to buy these stock picks monthly or bi-weekly? Has anyone played with numbers accounting for fee’s on a montly/biweekly basis?

  • FT FrugalTrader March 3, 2009, 9:53 am

    Kyle, providing that the borrowed amount is invested in “(potentially) income producing assets”, then the interest is tax deductible. With regards to reducing your fees, there are a few options:
    1. Sign up with a low cost brokerage.
    2. Accumulate your credit available before making a purchase. Ie. wait until you have $1k-$2k available.
    3. If you are considering purchasing dividend stocks, then consider DRIPing/SPP the stock. That way, you can purchase small amounts without any transaction fees.
    4. Buy low cost mutual funds that allow small amounts to be invested on a monthly basis.

  • mfd March 3, 2009, 10:14 am

    Option 1 would appeal to me depending on the amount of dividend income being generated. However I still feel there would be a real desire for me to pay off the entire heloc.

  • DividendMan March 3, 2009, 11:39 am

    I’m planning on using the dividends to payoff loans and new funds to buy more investmetns (without using more leverage) once I get to the level of leverage I am comfortable with.

    This way I can still dollar cost into the market and slowly but surely pay down that “good” debt.

  • CanadianFinance March 3, 2009, 12:35 pm

    I’m going to start a SM this year when I buy a new house.

    While I certainly have time to decide what to do when the mortgage is paid off, one idea I had for when that time comes was to stop making the regular “mortgage” payments and let the dividends pay down/off the loan.

    This would free up money so I can truly feel mortgage free, and since the dividends will have always been going to the debt, I won’t miss them when they’re still doing the same thing.

  • Ray March 3, 2009, 12:43 pm

    I am not an expert at the SM still studying it, just wondering. The main point of SM is to have your mortgage interest deductible, if your property is a rental property and producing income, the interest is already tax deductible why would you want to implement the SM?

  • cannon_fodder March 3, 2009, 12:51 pm

    Depending on your time horizon, another option not mentioned is to use an RRSP meltdown approach.

    If you are generating sufficient income from pension, investment dividends, government handouts, etc., you may want to look at withdrawing money from your RRSP to pay the interest on the investment loan. Because the interest write off and RRSP withdrawals are calculated at your marginal tax rate, it will be a ‘wash’ come tax time (you could end up getting a refund on the withholding tax from the RRSP withdrawals).

    If you can withdraw 4% from your RRSP annually (the theoretical amount that can be withdrawn without affecting the principal over time) and that covers your interest costs, then this could work for you in perpetuity.

    Another thing to keep in mind is that if you have a long time horizon, your investments should outpace inflation while your HELOC balance should, when factoring in inflation, go down.

  • FT FrugalTrader March 3, 2009, 1:20 pm

    CF, that is an interesting strategy. The issue I have with that is if you’re constantly withdrawing from your RRSP, it could mess up your portfolio allocation. Perhaps it could be considered when the distributions from the fixed income within the RRSP is enough to cover the investment loan servicing fees.

  • Qubikal March 3, 2009, 1:52 pm

    With a SM portfolio and investment loan in place, once the mortgage is paid off (still a few years away), I would like to start accumulating real estate properties (ie, buy a 2nd house and rent out the first house).

    Assuming that you would need to take another mortgage out for the new house, what are some suggestions to structure the purchase (and still maintain an investment portfolio)?

  • CanadianFinance March 3, 2009, 3:34 pm

    cannon_fodder,

    RRSP meltdown looks like a great idea, I will look into that!

  • ldk March 3, 2009, 7:54 pm

    We are doing option #2 currently….we paid off the mortgage portion of our HELOC about 2 years ago, and continue to make the same monthly payment to pay down the investment portion….will continue to make payments until the entire loan is retired. (about 3 years currently, unless we decide to take advantage of the low rates to purchase more ‘fire-sale-priced’ equities!)

  • Kyle March 4, 2009, 8:11 am

    Ray,
    With the investment property I would be paying down the principle HELOC mortgage and steadily increasing my portfolio investment, all at someone else’s expense (Rent=mortgage payment=advanceable investment loan) I would simply be creating more deductible interest. My mortgage interest is tax deductible but then the Investment Loan would become deductible as well, So I would in theory be carrying the same amount of deductible interest for a very long period of time. If i did not create an investment loan out of the mortgage, I would be decreasing the amount of deductible interest every year, thus paying more taxes, but if I could deduct interest from a loan as well, I would be steadily deducting the same interest year after year, make sense?

  • Matt March 4, 2009, 8:10 pm

    FT: I think you hit on a very important idea here – the exit plan. I found I was spending so much time on acculumulating my net worth, paying off primary residence, and producing new streams of cash flow that I had to stop and ask myself when do I want it to stop??

  • Elisa March 5, 2009, 12:16 am

    Hi, sorry, I’m not on this site often enough so I’m not sure if this has been brought up already, but I was looking into SM as well and a friend sent me a link where it says there was recently a court ruling that says we “cannot convert a mortgage to tax deductable interest” – the link:

    http://www.yourhome.ca/homes/article/578887

    if this was brought up already, can someone please refer me to the place where I can find the discussion and/or tell me what the net outocme of the discussion was?

    Thanks!

  • FT FrugalTrader March 5, 2009, 10:13 am
  • Ed Rempel March 13, 2009, 9:26 pm

    Hi Elisa,

    Bob Aaron has published several articles on the SM and is 100% wrong on all of them. He always quotes Dan White, who has no tax qualifications and is flogging some crazy tax scheme. 100% of accountants and tax experts in Canada will disagree with them.

    I’m surprised that any newspaper even publishes their crap.

    Ed

  • Keen Newbie Investor March 19, 2009, 4:44 am

    Hi FT,

    I have an interesting opportunity that I would like to put forth for advice from yourself or other followers.
    I have a professional school LOC that still has significant borrowing room (about $125 K). I will be done my degree shortly and will start a high cash earning job.

    The LOC has 1.5 years before the bank gives the options of creating a repayment plan or reapplying for a new LOC based on your new professional status. The reapplication has previously been granted 95% of the time, but given the current banking situation it’s possible it may be difficult to get re-approved.

    I had always read about the SM and am very comfortable with long term, high equity investing. I am particularly keen on Bogle’s concepts and index investing for the long term. My wife and I are under 30 and have long income earning years ahead.

    I have the added benefit that my wife is in the same professional program with the same LOC. I can transfer all personal debt to 1 LOC and leave the other as a purely investment LOC. We can realistically paydown our personal debt in 2-3 years based on our current lifestyle, while making our current mortgage payments (no accelerated paydown)

    What do you think about leveraging my LOC with ~$50 K- 75 K bought into diversified index funds (likely iShares and Vanguard) purchased monthly or bimonthly through a discount brokerage over 4-6 months to lessen the market timing effect/ obtain dollar cost averaging over that period?

    I see this current market downturn as a significant buying opportunity and figure I’d have the 50-75 K invested 5 years from now anyway, so why not get a head start and have some sizable tax refunds to help with mortgage paydown?

    My wife is on board with aggressive investing/ concept of leverage for the long term, but needs more convincing regarding DIY investing. We also have fairly secure, recession proof jobs that shouldn’t leave us hanging w/o income to pay this debt down.

    Thanks for any comments and advice.

    BTW, I plan to discuss this with a financial planner/ other professionals

    Keen Newbie Investor

  • Keen Newbie Investor March 19, 2009, 4:57 am

    Forgot to mention that the LOC’s are @ prime and the reapplication LOC is generally always at prime

    Keen Newbie Investor

  • FT FrugalTrader March 19, 2009, 8:25 am

    Keen Newbie Investor,

    Sounds like you guys have a great financial situation, congrats!

    I can’t really tell you if it’s a good idea or not to leverage, that’s a personal decision. If you can easily tolerate the risk and the volatility of the market, then sure, leveraging may be a good idea for the long term.

    A few things to note though:

    • Even though you have your LOC at prime right now, there aren’t many prime LOC’s being offered anymore. When it comes time to renew, don’t be surprised if your rate jumps to prime + 1 or more.
    • Leveraged investing has larger advantages for high income professionals like yourself as the tax deduction will be larger.
    • If you are going to use a LOC to invest with, make sure that you don’t use that account to spend on anything else. Ie. Use it for investing only.

    Those are just a few things off the top of my head, anyone else?

  • Brian March 19, 2009, 9:39 am

    KNI, I’m currently borrowing at prime to invest as well. I do a somewhat different approach in that I’m currently investing in dividend paying investments. Right now, the cost of borrowing is covered by the dividend payments. (Financials..preferred shares). Here are some of the things that you might want to consider..

    – Keep proper records of your interest payments for tax purposes
    – As FT says, you need to see how you can tolerate the risk so instead of taking the lump sum and investing it, divide it into portions and invest so that you get a sense of your tolerance level.
    – If you plan on investing in dividends, once you decide on your investment portfolio/stocks, you could wait to purchase near the ex-divi date so you get 3 months worth of dividends but borrowing cost at a week or 2.
    – Some of the risks are interest rate, asset value, dividend safety and your ability to pay the interest payments.

    Brian

  • Patrick April 1, 2009, 4:55 pm

    Did you forget the option of selling the investments to pay off the loan, and becoming debt-free?

  • pedro April 6, 2009, 1:01 pm

    i was wondering what people think of patricks option. Is this a good or bad idea and why because this was how i was planning to pay off my loc and heloc eventually down the road (ie>15yrs). Any feedback on this or the other options would be great guys thanks

  • Ed Rempel July 19, 2009, 2:32 am

    Hi Patrick & Pedro,

    Whether or not your pay off the loan should depend mainly on your comfort with leveraged investing.

    The average Canadian couple will live 30 years after they retire (retire at 62 and last to die averages age 92), which definitely qualifies as “long term investing”.

    For this reason, if you invest effectively, you will most likely have both higher income and lower tax if you keep the SM going. Remember it is “good debt”. You can pay it off any time, but you make a profit in the long run, so you are probably better off with the debt (and the investments).

    Over the 30 years, there will be on average 6 bear markets, but the markets always come back (if your withdrawal rate is reasonable).

    The lowest 30-year return ever for the S&P500 was 5.1%/year. Interest rates after tax have always been lower than this for all 30-year periods.

    It comes down to having faith in your investments (and in the markets, free enterprise, and humanity). We believe that if you don’t have faith in your investments, you should not do the SM in the first place.

    Ed

  • Ed Rempel July 19, 2009, 2:46 am

    Hi again Patrick & Pedro,

    The other issue regarding keeping the SM going for life or paying it off is about your tax bracket after you retire. Many Canadians (probably about half) will be in higher tax brackets after they retire than while they are working – once you include the clawbacks on the various government programs for all seniors.

    Essentially anyone over 65 with a taxable income less than $21,000 or over $41,000 is at the highest marginal tax bracket (45-50% or higher). If you are likely to be in any of these tax brackets after age 65, then the interest deduction would benefit you even more than it does today.

    You may need a different investment philosophy if you are focusing on dividends. Dividends are highly tax for about half of seniors, since the clawbacks are on the “grossed-up” dividend.

    For example, if you are over 65 and your only income is $1,000 of eligible dividends, you will lose $730 of it to the government! That is because you would qualify for the GIS supplement, but there is a 50% clawback. It is reduced by $.50 for every dollar of income. This clawback is on the grossed-up dividend, so your $1,000 dividend will be grossed-up to $1,450 of taxable income – and your GIS income will be reduced by half of this.

    For seniors with income below $21,000 or over $41,000, it is more effective to avoid dividends. (There is an article on this site about clawbacks for seniors with more info.)

    So, if you plan to keep the SM after retirement, you may want to change your investment strategy.

    Ed

  • Patrick July 20, 2009, 10:59 am

    @Ed: Could you explain why seniors making over $41k want to avoid dividends? I thought clawbacks only applied to the under-$21k group.

  • FT FrugalTrader July 20, 2009, 11:17 am

    Patrick, the OAS clawback starts on incomes above $66k. The dividend gross up counts as income when calculating the OAS clawback threshold.

  • Ed Rempel July 23, 2009, 1:06 am

    Hi Patrick,

    There is also the age credit clawback of 15% and the GST clawback of 5%, both of which start at an income of about $32,000 for 2009. This is a total 25% clawback in addition to income tax.

    This clawback is based on the gross-up for dividend income. With the 45% gross-up, there is a 20% clawback on dividend income in addition to income tax starting at an income of about $32,000.

    The GST clawback is only on income up to about $40,000, but the 15% clawback on the age credit applies all the way up to income of about $67,000. It overlaps the start of the OAS clawback a bit.

    So, one clawback or another applies for all income for seniors under $22,000 and between $32,000 to $105,000. The only seniors at low tax brackets once you include the clawbacks are those in the narrow income level between $22,000-32,000.

    There are more details in an article on this site about Clawbacks for Seniors ( https://www.milliondollarjourney.com/tfsa-vs-rrsp-clawbacks-income-tax-on-seniors.htm ). The article shows 2007 rates which are quite similar, except for 2 years of inflation on the tax bracket income levels.

    Ed

  • Ed Rempel February 12, 2010, 3:05 am

    Hi All,

    If you want a good laugh, here is an update on Dan White, who criticized the SM based on the Lipson case. See post 16 above.

    Here is a link to Jamie Golombek’s web site and an article about Dan White called “Dumb Write-offs”:

    http://www.jamiegolombek.com/printfriendly.php?article_id=916

    Read especially the tax deductions claimed in the last several paragraphs. :)

    Ed

  • sharp21 May 17, 2011, 5:56 am

    What about using the investment loan to purchase bonds or GIC’s? By the time your mortgage is converted the value of bonds should be equal to the amount of the investment loan.

    At the point the mortgage is fully converted you could sell the bonds & pay the loan in full. The benefit would be paying your mortgage off much faster & thus freeing up that monthly income with which you could then invest into a non-leveraged account.

    Any flaws in this approach, besides missing out on the compounding interest?
    S.

  • Ed Rempel December 24, 2011, 3:56 pm

    Hi Sharp,

    I just noticed your post. The most obvious problems with your idea is that you would lose money consistently and you lose the tax advantages.

    The interest rate on bonds or GICs is probably lower than the interest you pay on your investment loan/credit line. Therefore, when the mortgage is fully converted, the bonds or GICs will likely be less than the credit line.

    In addition, the interest on the bonds or GICs would be fully taxable each year, which would offset the interest deduction. If you have no chance of making a profit, your interest deduction would be limited to the interest you make on the GIC or bond.

    It sounds like you see the benefits of leverage, but are looking for a risk-free way to do it. If you are looking for a risk-free strategy, then probably the Smith Manoeuvre and other leverage strategies are probably not appropriate for you.

    Here is the bottom line: Leverage is the strategy used by all wealthy people to become wealthy and can work very well as a long term strategy with good quality, tax-efficient investments. However, it is a risky strategy. You can mitigate the risk by making it a long term strategy, having a sound investment strategy, making sure you can tolerate the inevitable ups and downs, and by getting good advice.

    However, there is no risk-free way to make lots of money leveraging. If you are going to do the Smith Manoeuvre, make sure you understand the risk and are able to tolerate it.

    Ed

  • Leo T. Ly @ isaved5k.com July 24, 2017, 9:25 am

    I am also using a variation of the Smith Manoeuvre to invest in the stock market. For me, instead of using the HELOC, I prefer to refinance my mortgage, lock in the interest rate for five years, and use the proceeds of the refinancing to invest. This way I can borrow more money faster as the market value of my house has increased significantly. Secondly, by locking in the interest rate for 5 years, I know my cash out flow to service my loans and I reduced the interest rate risk for five years. I have pulled this manoeuvre three time within the last ten years to build a stock portfolio of over $500K. I am hoping to do it a fourth time in the coming months.

    • Chrissy October 13, 2017, 3:34 am

      Leo – I like how you’ve done the SM. I’m a savvy investor, comfortable with risk and fully understand the strategy. Fraser Smith says you should get a financial planner experienced with SM to help you. Is this what you’ve done, or do you do it on your own?

      And if anyone else has their own experiences to add, I’d also love to hear from you!

  • GYM July 28, 2017, 6:07 pm

    Great post! I was always interested in the Smith Manoeuvre but never got the guts to take the plunge as I am debt averse (other than my mortgage loan). It does sound like a great strategy to get some tax deductions since there are so few tax deductions out there for us. With the interest rates rising (and next one to be announced in a few months), has this affected your interest in paying down the HELOC for investment, FT?

    • FT FT July 28, 2017, 7:43 pm

      Hi GYM, no plans to pay down the HELOC yet, interest rates would need to increase substantially before I would consider paying down the HELOC.

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